Glossary
Terminology to help You Achieve Success
Uncertain of a phrase or word related to trading? Read through our Glossary to find the explanation you're looking for!
Long Call Option
A call can be purchased to open a long call position. As in the case of long stocks it is a debit trade. The call is purchased at the Ask value of the options strike price based on the expectation that the stock price will rise. It gives you the right to buy the stock at a fixed price within a set time frame. So a long call can be used when you expect the market to trend upwards in a bullish manner. The call purchase gives you the rights to:
The call purchase gives you the rights to:
- Subsequently sell the option
- Exercise the option
- Let the option expire
You do not want to let the option expire because you will lose your investment in the call purchase. You could also exercise the option. In this case you must have the capital available to purchase the stock. So if you have executed a directional trade through the purchase of a call option, you will most likely want to subsequently sell the option to capture profits.
Example:
Based on your analysis you believe stock ABC will rise in value from its current price of $40/share and so you purchase a 40 June Call. Let's say you buy 1 contract equating to 100 shares of stock. And consider the option price is $2/share or $200/contract. So you now control 100 shares of ABC stock for $200 by purchasing the call option where you would have spent $40/share x 100 shares equal to $4,000 if you had purchased the stock.
So you have purchased a 40 June Call costing $2/share. If the stock increases to $45/share this gives you the right to buy the stock at $40 (as the number 40 represents the strike price). You have the right to buy this stock until June at which point the option will expire. Options expire on the Saturday following the 3rd Friday of the month (options cease trading on the 3rd Friday of the expiration month) of the month, in this case June. As the stock increases in value so too will the option. This allows you to re-sell the option at a profit without ever having owned the stock.
Long Put Option
A put can be purchased to open a long put position. As in the case of long calls it is a debit trade. The put is purchased at the ask value of the option's strike price based on the expectation that the stock price will fall. It gives you the right to sell stock at a fixed price within a set time frame. A long put can be used when you expect the market to trend downwards in a bearish manner. The put option will increase in value as the stock trends downwards. So, you can sell that put at a profit as the value of the stock decreases.
The put purchase gives you the rights to:
- Subsequently sell the option
- Exercise the option
- Let the option expire
Similarly to the case of call options you will not want to let the option expire, as you will lose your investment in that trade. You can also exercise the option which, in this case means selling stock at a fixed price. For the most part you will want to sell the option to capture premium when the option becomes profitable.
Example:
Consider the same company ABC as before trading at $40/share. Based on your analysis you expect the stock to decrease in value from its current price so you buy a 40 June Put. If the cost of purchasing the put option is $2/share and you buy 1 contract you will pay $200 (since 1 contract equates to 100 shares).
The number 40 in "40 June Put" refers to the strike price and is the value at which the stock can be sold. As in the case of the call option contract above, the put option will cease trading on the 3rd Friday of June. If the value of the stock drops to $35 this gives you the right to sell stock ABC at $40/share and therefore if you own the stock it protects you against a downtrend in the stock.
Options Chain
In order to understand option chains, some examples will be discussed. The format shown is typical of brokerage representations.
| CALLS | PUTS | |||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Symbol | Last | Chg | Bid | Ask | Volume | Open Interest | Strike | Symbol | Last | Chg | Bid | Ask | Volume | Open Interest |
| JUNE CALLS | XYZ @20.87 | JUNE PUTS | ||||||||||||
| XYZFW | 3.600 | 0 | 3.600 | 3.700 | 64 | 11,752 | 17.50 | XYZRW | 0.200 | 0 | 0.200 | 0.250 | 430 | 5,709 |
| XYZFD | 1.650 | 0 | 1.650 | 1.750 | 429 | 7,821 | 20.00 | XYZRD | 0.800 | 0.1 | 0.650 | 0.800 | 592 | 6,409 |
| XYZFX | 0.500 | 0 | 0.500 | 0.550 | 683 | 4,111 | 22.50 | XYZRX | 2.050 | +0.1 | 2.050 | 2.200 | 85 | 711 |
| XYZFE | 0.100 | 0 | 0.050 | 0.200 | 12 | 1.382 | 25.00 | XYZRE | 4.100 | 0 | 4.100 | 4.300 | 1 | 142 |
The first thing you should pay attention to in the above chain is the symbol and stock price located under the Strike column. You can see that this is the option chain for XYZ and that the stock is trading at $20.87.
The second piece of critical information is the expiration month - June in this case - shown in the adjacent columns and labeled as June Calls and June Puts. So these call and put options cease trading on the third Friday of June.
Under the middle column are the strike prices. Note that these are fixed prices. All the other numbers on the options chain can change depending on the stock price. So, if the stock price rises the calls will increase in value to reflect the increase in stock price and the puts will decrease in value to represent the stock value increase. The reverse will happen for a decrease in stock value.
Note that each call and put option has its own unique symbol. This is listed on the extreme left column for calls. The calls are used to identify the option (call/put), its strike price, expiration month and stock. It is not necessary to have an in-depth understanding of this, just the overall concept. Similarly the put options on the right side have unique symbols. These symbols will help you place trades by identifying which option you wish to buy or sell.
When you buy the option you will be purchasing it at the Ask price and when you sell the call or put option you will be selling at the Bid price. Note that the Ask price is always slightly greater than the Bid price. The difference is called slippage or spread and is the profit that the market maker receives by ensuring liquidity in the market place. So if you buy an option you are not going to sell it right away or you will lose money.
So if you wish to buy a June 20 Call you will pay the ask price of $1.75 per share and since you will purchase a minimum of 1 contract equivalent to 100 shares, this equates to $175 per contract. Similarly if you wish to purchase 1 June 20 Put contract you will pay $0.80 per share or $80.00 per contract.
If you wish to sell the June 22.50 call you will receive the bid price of $0.50 per share. And for the June 22.50 put you will receive $2.05 per share or $205 per contract.
If you wish to sell the June 22.50 call you will receive the bid price of $0.50 per share. And for the June 22.50 put you will receive $2.05 per share or $205 per contract.
In order to understand the terms "in-the-money", "at-the-money", "out-of-the-money", "intrinsic value" and "extrinsic value" mentioned in the options terminology section above, consider the following examples
In-the-money: In the options chain listed, the figures highlighted in yellow are in-the money. You know that the stock is trading at $20.87. In the case of the call options this means that any call options with strike prices less $20.87 will be labeled "in-the-money". You can see that the June 17.50 and June 20 calls are therefore in-the-money.
The term "in-the-money" for the listed call options is effectively saying that while the stock is greater than their strike price, the call option always has some value at least equal to the difference between the stock price and the strike price. So, when you're in-the-money your option will always have intrinsic value. In the case of the June 20 call the intrinsic value is $0.87 which is the difference between the stock price and the strike price.
Note that this June 20 call option is in fact trading for a Bid price of $1.65 and an Ask price of $1.75, both of which are greater than the $0.87. This extra cost is the extrinsic value of the option and represents time value.
Conversely for puts, options that have strike prices greater than the stock price are said to be in-the-money. The June 22.50 put will have intrinsic value that equals the strike price minus the stock price (22.50-20.87 = 1.63). The option in fact trades at a bid value of $2.05 per share and an Ask value of $2.20 per share. The difference between the intrinsic value and the actual value is the extrinsic value.
Therefore, put options with strike prices higher than the current stock price are said to be in the money.
In summary when you have an option that is in-the-money, the option will have intrinsic and extrinsic value.
Out-of-the-money: The call and put options that are not highlighted in yellow are said to be "out-of-the-money". This is because the stock price is lower than the strike price in the case of the call options and higher than the strike price in the case of put options.
In the case of the June 22.50 call option, its entire value is extrinsic value. The option has no intrinsic value because the strike price is greater than the stock price. Similarly, the June 17.50 put option has no intrinsic value because the strike price is less than the stock price.
At-the-money: At the money means the value of the stock is equal to the value of the strike price. In the case above there is no option strike price equal to the stock price of $20.87 therefore no options exist at-the-money. If the stock were to decrease in value to $20 then the June 20 call and June 20 put would be at-the-money.
Summary:
Options trading instruments take the form long call, short call, long put and short put options. Trading these instruments alone can facilitate directional trading that will allow you profit in the market in one direction alone.
Options Terminology
Strike Price
All equity options have a specific price at which a stock can be bought or sold if the option is exercised. This is the strike price or exercise price. If you own a call option you can exercise your right to buy 100 shares of a particular underlying stock at the specified strike price. Similarly if you own a put option, you can exercise your right to sell 100 shares of a particular underlying stock at a specified price.
Expiration Date
Expiration date is the last day on which an option can be exercised. Options cease trading on the third Friday of each month and expire the next day.
In The Money*
An option with intrinsic value is said to be in-the-money. A call is in-the-money when the market price of the underlying stock is greater than the option's strike price.
At The Money*
When the underlying stock sells at the same price as the strike price of the option, the option is said to be at-the-money
Out Of The Money*
If an option has no intrinsic value, it is considered out-of-the-money. A call is out of the money when the strike price is higher than the market price of the underlying stock. A put is out of the money when the strike price is lower than the market price of the underlying stock. The entire premium of an out-of-the-money option is due to its time value.
Open Interest
Open interest is the number of outstanding contracts and can be used to determine group expectation for a particular stock.
Intrinsic Value*
Intrinsic value is the difference between an in-the-money option's strike price and the current market price of a share of the underlying stock.
Extrinsic Value*
Extrinsic value is any other value the option has over and above the intrinsic value. EX: Long Call Strike 50 that costs $3. Assume Stock is at $51. Intrinsic value = $51 - $50 = $1 Extrinsic value = $3 - $1 = $2
Volume
For options this the number of contracts that have been traded in a specific time period, usually a day or week.
Implied Volatility
Implied volatility is the assumption of the stock's volatility that helps determine the options price. All other factors in the options pricing model are assumed to be known so the implied volatility is calculated last after other options pricing parameters have been calculated. Increased implied volatility increases the value of an option and decreased implied volatility decreases the value of an option. It can be thought of as the value of an option based on current market sentiment of future fluctuations in the stock. So news events such as earnings releases, upgrades and downgrades will affect implied volatility.
Time Value
Time value or time premium is the difference between the total cost of an option and its intrinsic value. So it's the amount people are willing to pay over and above the intrinsic value. It is length of time from the date of purchase to the expiration date. The further out the expiration date the greater the time value.
Time Decay
This is the loss in value of an option over time when all other factors remain constant. It is a non-linear decrease with the greatest effect being in the last 30-45 days of an option's life. So in the last 30-45 days if you own a long option it would be prudent to re-sell that option or exercise that option because time decay will be acting against you. So time decay causes long options to lose value. Conversely if you short options, time decay is working for you.
Delta
This is the rate of change of the options price relative to a one unit change in the price of the stock. For example if a call option has a delta of 0.75 then for a $1 increase in the price of the stock the option will increase by $0.75
Assignment
A random process in which options buyer informs broker of wish to exercise option. Broker informs options exchange that in turn informs options clearing corporation. OCC returns to options exchange that randomly picks a broker and the broker picks a short option holder to assign by a fair but not necessarily random method.
Options Trading Instruments Summary
| Option | Trend | Stock > Strike Price | Stock < Strike Price |
|---|---|---|---|
| Long Call | Bullish | Right to
|
Option purchase investment will lose value, may be able to re-sell and capture time value premium |
| Long Put | Bearish | Option purchase investment will lose value, may be able to re-sell and capture time value premium | Right to
|
| Short Call | Stagnant/Bearish | Obliged to sell stock if assigned | Let option expire & capture entire premium as profit - combine with stock purchase |
| Short Put | Stagnant/Bullish | Let option expire & capture entire premium as profit | Obliged to buy stock if assigned |
Short Call Option
A call can be sold to open a short call position. The call is sold based on the expectation that the stock will decrease in value. The short call obligates you to sell a stock at a fixed price within a set time frame. Since you are giving someone the right to buy the stock from you, you receive a premium for providing them the right and so the trade is a credit trade. The premium you receive is the Bid value of the options strike price.
In a directional trade the call is sold because you believe, based on your analysis, that, the stock will decrease in value. As part of a spread trade the short call is very effective in reducing cost basis.
For now consider only the case of the short call as a directional trade. If the stock rises in value above the strike price of the call you are obligated to sell the stock at the given strike price.
The short call obligates you to:
Sell the stock if assigned
Assignment means that you are obligated to carry out some action. In this case it means you are obligated to sell the stock. Effectively somebody previously purchased a call and has exercised their right to buy the stock at a fixed strike price and since you sold the call at that strike price you are obligated to sell the stock at that strike price.
Selling a call without combining it with any other trade is called a naked call. Brokerages have strict requirements about naked calls, such as account minimums of $100,000. The reason for this is that in theory the risk is unlimited if the stock should soar above the strike price. It is for this reason that it is generally encouraged that you do not sell calls unless it is in combination with another trade, such as a covered call. And in the case of a covered call it can actually be a very effective way of proactively generating cash flow and hence increasing portfolio value.
The intention in selling the call is to capture premium by allowing the option expire worthless based on your analysis and expectation that the stock will not rise above the strike price within a set time frame.
Example:
Consider the same company ABC as before trading at $40/share. Let's assume you own the stock. Based on your analysis you don't expect the stock to rise in value above $45 so you sell/short a 45 June Call. And for selling the call you receive a premium of say $2.00 per share or $200 per contract. This premium is deposited into your account upon trade execution. If the value of the stock remains less than $45 during the set time period then the 45 June Call will expire worthless and you will keep the entire premium of $200 per contract. If you owned 1000 shares of stock and sold 10 contracts you would have profited $2/share x 1000 shares or $2,000 provided the stock stayed below $45/share until the 3rd Friday in June.
If the value of the stock exceeds $45/share then you will be assigned the option at expiration and must sell stock ABC at $45/share. So you will profit in the stock from $40 to $45 and you will also profit from the option premium received. However, you will not profit from any increases in stock price above $45/share.
Short Put Options
A put can be sold to open a short put position. The put is sold based on the expectation that the stock will increase in value. The short put obligates you to buy a stock at a fixed price within a set time frame. Since you are giving someone the right to sell the stock, you receive a premium for providing them the right and so the trade is a credit trade. The premium you receive is the Bid value of the options strike price.
In the case of short put options your risk is limited to the strike price of the put. For example if you sold a put option at a strike price of $20 and the stock dropped all the way to zero you would have received a premium for selling the put, say $2/share, but would now have to purchase the stock at $20/share if assigned.
The short put obligates you to:
Buy a stock if assigned
So if somebody purchased a put and exercises their right to sell their stock at the set strike price at which you sold the put, then you would be obliged to buy the stock at that same strike price. This is only likely to ever happen if the stock drops below the strike price.
Example: Consider the same company ABC as before trading at $40/share. Based on your analysis you believe the stock will increase its price per share so you sell a put option to generate credit with the intention of letting the option expire worthless.
So let's say you short a 40 June Put and receive $2/share premium. This $2/share premium is the maximum profit potential of the short put directional trade and the funds are deposited in your account upon trade initiation. If the stock is less than $40/share you will be obliged to buy the stock at $40/share (i.e. the stock price is lower than the strike price). If the stock is greater than $40/share you keep the entire premium of $2/share or $200 per contract
Stock Market Terminology
Stock Exchange
Association or body of brokers who are engaged in the business of buying and selling stocks, options and commodity futures.
Broker
An individual or firm that acts as an intermediary between a buyer and seller, usually charging a commission.
Stockbroker
Broker who deals primarily with transactions involving stock
Trader
One who buys and sells securities for his/her personal account, not on behalf of clients
Market Maker
A brokerage or bank that maintains a firm bid and ask price in a given security (e.g. stock, option, bond) by standing ready, willing and able to buy or sell at publicly quoted prices (called making a market). These firms display bid and ask prices for specific numbers of specific securities, and if these prices are met, they will immediately buy for or sell from their own accounts. Market makers are very important for maintaining liquidity and efficiency for the particular securities that they make markets in.
Stock Price
Agreed upon price by a buyer and seller of stock. Stock prices are quoted on per share basis and are quoted with both bid and ask price.
Bid Price
The price one receives for selling a stock or option. When demand exceeds supply, buyers are willing to raise their purchase or bid price.
Ask Price
The price at which one buys a stock or option. When supply exceeds demand, sellers have to lower their sale or ask price.
Slippage
The amount one loses between the bid and the ask prices. The market maker profits from the difference between the two prices for creating liquidity in the market.
Order
A request from a client to a broker to buy (buy order) or sell (sell order) a specified amount of a particular security at a specific price.
Market Order
A buy or sell order in which the broker is to execute the order at the best price currently available. These are often the lowest commission trades because they require very little work by the broker. The price at which the order is filled cannot be guaranteed and may vary from the figure quoted on the computer screen.
Limit Order
An order to a broker to buy a specified quantity of a security at or below a specified price, or to sell it at or above a specified price. This ensures that a person will never pay more than whatever price is set as his/her limit. This is one of the two most common types of order, the other being the market order. Limit orders guarantee the price at which the orders are filled provided the security reaches the price set. If the price is not reached the order may never be filled however it does allow the trader/investor control over what price the trade is entered or exited
Stop Order
A stop order is a market order to buy or sell a certain quantity of a certain security if a specified price is reached or passed. A stop order does not guarantee you will get filled at the exact stop order price because once the price is reached it becomes a market order
Stop Limit Order
An order to buy or sell a certain quantity of a certain security at a specified price or better, but only after a specified price has been reached. It is essentially a combination of a stop order and a limit order.
GTC (Good-Till-Canceled)
An order to buy or sell which remains in effect until it is either executed or canceled. Brokers usually set limits of 30 or 60 days after which the order is automatically canceled.
Day Order
A buy or sell order which automatically expires if it is not executed during that trading session.
Fill-Or-Kill
An order given to a broker that must be filled in its entirety or, if this is not possible, canceled.
All-Or-None
A stipulation of a buy or sell order which instructs the broker to either fill the whole order or don't fill it at all; but in the latter case, don't cancel it, as the broker would if the order were a fill-or-kill.
Long
When a stock or option is owned, one is said to be long the stock or option e.g. Joe Trader is long 100 shares of ABC stock means Joe Trader owns 100 shares of ABC stock.
Short
Borrowing a security from a broker and selling it with the understanding that it must later be bought back (hopefully at a lower price) and returned to the broker. Short selling is a technique used by investors who try to profit from the falling price of a stock. For example, consider an investor who wants to sell short 100 shares of a company, believing it is overpriced and will fall. The investor's broker will borrow the shares from someone who owns them with the promise that the investor will return them later. The investor immediately sells the borrowed shares at the current market price. If the price of the shares drops, he/she "covers the short position" by buying back the shares, and his/her broker returns them to the lender. The profit is the difference between the price at which the stock was sold and the cost to buy it back, minus commissions and expenses for borrowing the stock. But if the price of the shares increases the potential losses are unlimited. The company's shares may go up and up but at some point the investor has to replace the 100 shares that he/she sold. In that case, the losses can mount without limit until the short position is covered. For this reason short selling is considered very risky. e.g. Jack Trader is short 100 shares of XYZ stock. This means Jack Trader has borrowed stock XYZ from a broker and sold it with the understanding that it must later be bought back.
